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ECON 1 – Section 19 – Page 23GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (cont ’ d) The multiplier can be found by the formula of the multiplier (obviously) = 1/(1-c) There is another way to solve it (more complicated), but I know you are curious.

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ECON 1 – Section 19 – Page 25GSI: R. EstopinaNov. 6 th, 2002 Problem 25.6 (Conclusion) By how much would autonomous AD have to change to eliminate the output gap? As the multiplier is 2, to eliminate the output gap of – 400, autonomous aggregate demand would have to change by – 200, that is, autonomous aggregate demand would have to fall. If autonomous aggregate demand falls from 6200 to 6000, then short-run equilibrium output equals 12,000 and the output gap is eliminated.

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ECON 1 – Section 19 – Page 32GSI: R. EstopinaNov. 6 th, 2002 Problem 25.7 (Conclusion) How these results help explain the tendency of recessions and expansions to spread across countries? The example shows that a weak economy in one country, by reducing that country ’ s imports from a second country, can create economic weakness in the second country as well. Similarly, an expansion that increases a country ’ s purchases of foreign products strengthens the economies of its trade partners.

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ECON 1 – Section 19 – Page 37GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) Now we can find the appropriate fiscal policies to eliminate the output gap. Because actual output exceeds potential output by 20, and the multiplier is 5, a decrease of 4 in government purchases (from 120 to 116) will eliminate the output gap. You can verify this directly by setting =116 and re-solving for short-run equilibrium output.

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ECON 1 – Section 19 – Page 38GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) By how much would taxes have to change? (Assume MPC = 0.8) For the case of a tax change we have to be careful. A change in taxes of ΔT does not change autonomous aggregate demand by ΔT, because consumers do not spend 100% of any tax cut (or reduce spending by 100% of any tax increase). A change in taxes of ΔT instead changes autonomous aggregate demand by cΔT, where c is the marginal propensity to consume (MPC) out of disposable income.

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ECON 1 – Section 19 – Page 39GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) In the case of government spending, eliminating the output gap requires reducing autonomous aggregate demand by 4. To reduce autonomous aggregate demand by 4 via a tax change, Gov. will increase taxes by 5. Since the MPC = 0.8, a tax increase of 5 will lead consumers to reduce their spending by 4, as desired. You can also verify it by setting =115 and solving for short-run equilibrium output.

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ECON 1 – Section 19 – Page 40GSI: R. EstopinaNov. 6 th, 2002 Problem 25.9 (cont ’ d) What happens if now Y*=630? If potential output is 630, then the output gap is Y*-Y=30, that is, there is a recessionary gap of 30. As the multiplier is 5, this gap can be eliminated by raising government purchases by 6. An increase in shifts the expenditure line upwards. AD OutputY*=630 600 Y=AD AD=120+0.8Y AD=126+0.8Y

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ECON 1 – Section 19 – Page 42GSI: R. EstopinaNov. 6 th, 2002 Problems for next sections !!! For next section: Chapter 26: Problems 3, 8, 9. Remember: This is not mandatory. It won ’ t be graded. Only for those of you that need improvement in Exam grades.

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ECON 1 – Section 19 – Page 43GSI: R. EstopinaNov. 6 th, 2002 Next class Next Class: Section 20 – Wednesday, Nov 13 th No class next Monday. Veterans Day Holiday. Due PS#4 !!!! If you want more practice, work on Next Sections Problems (although you probably have enough). Read ch. 26 & 27. You can download handouts this afternoon. Thank you for coming on time !!! Enjoy the long weekend & C-U Wednesday !!.